Q&A on QE2: What a Fed Move Would Mean

The Federal Reserve is expected to announce a new round of bond-buying today to lower long-term interest rates to boost the economy.

Debate is raging inside and outside the Fed about how much good it will do, if any. Proponents say purchasing hundreds of billions of dollars more in Treasury bonds will provide only modest support for the economy. Foes warn that it could backfire by pushing up commodity prices, sowing seeds of unwelcome inflation in the future, or by undermining confidence in the Fed’s ability to manage — and eventually reduce — its holdings.

Ahead of the Fed’s 2:15 p.m. announcement, here’s a rundown of the key issues:

What is quantitative easing, or QE?

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The Federal Reserve building

It’s the electronic equivalent of starting up the Fed’s printing presses to create money for buying financial assets in the market – in this case long-term U.S. Treasury bonds. Buying bonds pushes down their yields, and the interest rates across the debt markets that are closely tied to U.S. Treasury rates.

How does the Fed expect QE2, as it has been dubbed, to influence the economy?

Lower borrowing costs should help some homeowners refinance, even if many others don’t qualify because of weak credit scores or diminished home equity. It also should help businesses that can qualify for loans through cheaper credit, though larger corporations already can access money at cheap rates. (One big question: will all the new liquidity will lead banks to lend more? They’re already sitting on more than $1 trillion of reserves without lending it out.) The Fed figures that buying up government debt, in theory, should push investors into riskier assets — such as stocks and corporate bonds — and raise their value. It also will tend to weaken the dollar, helping U.S. exporters be more competitive in overseas markets.

What did the first round of QE accomplish?

From December 2008 to March 2010, the Fed bought $1.7 trillion of Treasurys and mortgage-backed securities. The move is widely credited with helping to pull the economy out of a freefall by lowering the yields on those securities, pushing down the interest rates for consumer, mortgage and business borrowing. New York Fed economists have estimated that the purchases lowered longer-term Treasury yields by about half a percentage point, an effect they say translated into lower rates across private credit markets and higher asset prices.

Why is the Fed planning another round of QE?

Even though the Fed has been holding short-term interest rates near zero since December 2008, the economy remains weak. The Fed is falling short on its two primary mandates: unemployment, at 9.6%, is well above “maximum sustainable employment” and inflation is running below what the Fed considers to be “price stability,” an informal target of 1.75% to 2%. Fed officials believe more bond-buying could push rates even lower, though they admit the effect may not be as pronounced as it was before. “The impact of securities purchases may depend to some extent on the state of financial markets and the economy,” Fed Chairman Ben Bernanke said in late August. “For example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high.”

How is QE2 different from the first round ?

The Fed’s first round of QE was designed around a clear target amount. It first announced a purchase of up to $600 billion in assets in November 2008 and expanded that goal in March 2009 to $1.7 trillion of Treasury debt, mortgage-backed securities and debt backed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The “shock and awe” announcement, during the depths of the financial crisis, and the markets’ response before the Fed actually made its purchases helped stabilize the economy. Now, with the economy expanding slowly (but expanding), the Fed is expected to proceed with purchasing assets at a measured pace, which it may adjust as economic conditions change. And this time the Fed is only buying Treasurys, in part because some officials had misgivings about targeting a particular sector of the economy by purchasing mortgage-backed securities and in part because the first round of purchases successfully shrunk an unusually wide gap between the rates on U.S. Treasurys and rates on mortgages.

How much could the Fed ultimately buy?

Most economists expect the Fed to buy $500 billion to $1 trillion, at a pace of about $250 billion or so a quarter. Some forecast the Fed ultimately will buy $1.5 trillion to $2 trillion worth of Treasurys to spur growth. There’s no legal limit to doing more, but the Fed would face some operational and technical challenges if it were to buy many trillions of dollars in additional securities. Among them: Buying several trillion dollars would be more debt than the U.S. government is actually issuing each year.

What are the risks?

No one, inside or outside the Fed, knows the precise effects, or the unintended consequences, of more bond-buying. Giving investors incentives to seek higher yields in riskier assets raises the likelihood of creating asset-price bubbles. The low rates of 2003-04 are believed by some analysts to be a major factor in creating the housing bubble, though Fed Chairman Ben Bernanke doesn’t think so. At some point – well before the economy has completely recovered — the Fed will need to withdraw all the money it’s printing now in order to avoid a surge in inflation down the road. Some investors don’t believe the Fed will be able to do that quickly enough, and fear inflation will result.

What effect would QE have on the dollar and overseas economies?

Printing more money tends to push down the value of the dollar. While that would tend to help U.S. exports, it also risks pushing up the price of oil and other commodities, threatening an inflation surge that could be difficult to stop if the economy picks up. The dollar already has fallen substantially, and the resulting flood of money to emerging markets with higher interest rates and more robust growth is pushing up their currencies more than some of their governments want. That has led some countries to intervene to resist the rise in their currencies, sparking tensions between the U.S. and emerging markets and talk of “a currency war.”

What else could the Fed do if the economy doesn’t pick up?

If QE2 shows even modest success in pushing interest rates down, the Fed could buy more. Central banks elsewhere have purchased corporate bonds, but the Fed says the law prohibits it from doing so except in “unusual and exigent circumstances.” Fed officials have discussed using firmer language to indicate that it plans to keep rates near zero for longer than markets now expect. They’ve also started talking about how to boost inflation from current low levels, essentially shooting for higher inflation for a time and ease any lingering worries that the U.S. is headed toward deflation. Higher inflation is a way to push “real” — or inflation-adjusted — interest rates down. That, the theory goes, would encourage more spending and investing and less saving.

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